What is an Absolute Value
The absolute value method differs from the relative value models that examine what a company is worth compared to its competitors. Absolute value models try to determine a company's intrinsic worth based on its projected cash flows.
Also known as Intrinsic Value.
BREAKING DOWN Absolute Value
Finding out whether a stock is under or overvalued is a primary play of value investors. Value investors use popular metrics like the price to earnings (P/E) and price to book ratio to determine whether to buy or sell a stock based on its estimated worth. In addition to using these ratios as a valuation guide, the discounted cash flow (DCF) valuation analysis is another way to determine absolute value.
With a DCF model, some form of a company’s future cash flows (CF) is estimated and then discounted to the present value in order to determine an absolute value for the company. The present value is regarded as the true worth or intrinsic value of the firm. By comparing what a company's share price should be, given its absolute value to the price that the stock is actually trading at, investors can determine if a stock is currently under or overvalued.
Examples of methods used under the DCF model include the dividend discount model (DDM), discounted asset model, discounted residual income method, and the discounted FCF method. All of these models require a rate of return or discount rate which is used to discount a firm’s cash flows – dividends, earnings, operating cash flow (OCF), or free cash flow (FCF) – to get the absolute value of the firm. Depending on the method employed to run a valuation analysis, the investor or analyst could use either the cost of equity or the weighted average cost of capital (WACC) as a discount rate.
For example, consider Tesla Inc. (TSLA) which is currently trading on the market for $370.50 (as of June 2017). After running a DCF analysis on its estimated future cash flows, an analyst determines that the absolute value of the firm is $450.30. This presents a buying opportunity for an investor who is led to believe, based on the numbers, that TSLA is undervalued.
Estimating a company’s absolute value is not without its setbacks. Forecasting the cash flows with complete certainty and projecting how long the CFs will remain on a growth trajectory is challenging. In addition to predicting an accurate growth rate, evaluating an appropriate discount rate to calculate the present value can be difficult. Since the absolute valuation approach to determining the worth of a stock is strictly based on the characteristics and fundamentals of the company under analysis, there is no comparison made to other companies in the same sector or industry. But companies within the same sector should be considered when analyzing a firm, since a market moving activity (e.g. bankruptcy, government regulatory changes, disruptive innovation, employee layoffs, mergers and acquisitions, etc.) in any one of these companies can affect how the entire sector moves. Therefore, the best way to evaluate a stock’s real value is to incorporate a mix of both the absolute and relative value methods.